EconSouth (Second Quarter 2000)

EconSouth (Second Quarter 2000)

Dozens of regional trading blocs, touted by member countries as boons to global free trade, have sprung up around the world in the past 15 years. But do such regional trading arrangements (RTAs) promote or impede trade with countries outside the bloc? Supporters of RTAs argue that they foster internal economic reform and liberalization that ultimately enhance global trade. One RTA, Mercosur in South America, has been hard hit by internal squabbles, but ultimately Mercosur seems to be a viable and effective trading bloc.

he emergence of Mercosur, which includes Argentina, Brazil, Paraguay and Uruguay (with Chile and Bolivia as associate members), has led to deeper economic ties within South America and has coincided with a rapid expansion of trade between the United States and the Mercosur countries. The success of Mercosur is an important step toward the eventual development of a hemispherewide Free Trade Area of the Americas agreement. Although there has been a series of trade disputes within Mercosur in recent months, tensions appear to be subsiding, and Mercosur's future appears bright.

CHART 1
Country Share of Mercosur GDP

Source: Economist Intelligence Unit

Disagreement
After a year of deteriorating trade relations, the process of economic integration in the Southern Cone of South America appears to be back on track. Mercosur experienced its worst crisis in its short history after Brazil's currency devaluation in January 1999. After the devaluation, Argentina and Brazil, which account for 90 percent of Mercosur's collective gross domestic product (GDP), found themselves involved in a series of trade disputes.

The devaluation sparked conflict within Mercosur over issues that had been simmering for some time. Brazil's currency lost as much as 42 percent of its value following the devaluation, while Argentina's currency remained pegged to the U.S. dollar. These developments made Argentine exports more expensive in Brazil and Brazilian exports cheaper in Argentina. This disparity, along with an economic slowdown in the region, contributed to a 28.5 percent drop in Argentine exports to Brazil in 1999; Brazilian exports to Argentina fell 20.5 percent during the same period.

Nevertheless, Argentina still maintained a $325 million trade surplus with Brazil. After the devaluation, some Argentine firms complained that they could not compete with cheaper Brazilian imports and requested government protection. The government responded by imposing import restrictions on Brazilian footwear, paper, pulp and textiles. Brazil protested the measures, and before long the two countries were engaged in a series of trade disputes that have now been mostly resolved, although a number of Argentine firms continue to petition the government for protection.

Perhaps the most sensitive sector of trade within Mercosur has been the automotive sector. Commerce in autos between Argentina and Brazil accounts for more than 30 percent of bilateral trade flows. The 58 percent drop in Argentine auto exports in 1999, largely due to a decline in exports of auto parts and components to Brazil, underscored the urgency of reaching an agreement. The situation was further aggravated by reports in the Argentine press that many firms were relocating at least part of their Argentine production to Brazil in order to take advantage of lower production costs.

The fact that several Brazilian states had been developing incentive packages to attract automotive firms to relocate production to their states caused further tension within Mercosur. The so-called fiscal war became a significant point of contention within Brazil when Ford decided to open a new plant in the northeastern state of Bahia rather than in the state of São Paulo, where it already had production facilities. In addition to causing tension between individual Brazilian states, the Argentine government complained that the incentives provided an unfair advantage to Brazilian producers. Some Argentine firms cite Brazilian state subsidies when they argue that their government should provide similar incentives in Argentina.

Underlying problems
The tensions that emerged within Mercosur during these trade disputes in 1999 underscored Mercosur's main structural weaknesses. First, Mercosur lacks an adequate institutional framework to deal with trade disputes between individual members. So when Brazil reached an impasse with Argentina over restrictions on textiles, it took the dispute to the World Trade Organization because there was not an adequate dispute resolution process within Mercosur.

What Is Mercosur?

hile Mercosur officially came into being with the Treaty of Asunción in 1991, it had its origins in the Latin American Free Trade Association (1960) and the Latin American Integration Association (1980). In 1988, Argentina and Brazil set the goals of eliminating tariff barriers, harmonizing macroeconomic policies and establishing a common market between the two countries. The arrangement, which eventually became Mercosur, came to include Uruguay and Paraguay. Chile and Bolivia became associate members in 1996 and 1997, respectively, and have signed free trade agreements with Mercosur.

Mercosur represents a combined market of 210 million people, with a GDP of over a trillion dollars. The Mercosur countries produce 50 percent of Latin America's GDP and contain 43 percent of its population and 59 percent of its total landmass. The per capita GDP of its four countries is 30 percent higher than that of Latin America as a whole. Argentina and Brazil dominate Mercosur, accounting for over 90 percent of the trading bloc's GDP.

Mercosur operates a customs union with largely tariff-free intra-bloc trade. It operates around a set of common external tariffs that range between 0 percent and 20 percent and apply to around 90 percent of tradable goods. Each country can maintain a list of exceptions of up to 300 items, but these are scheduled to be phased out by the end of 2000. There is an additional list of exceptions, including autos, sugar, telecommunications equipment, computer equipment and capital goods, that are scheduled to converge toward the common external tariff between 2004 and 2012. The average tariff for Mercosur member countries is 14 percent.

The ultimate goal of Mercosur is to create a common market that would allow the free mobility of all production factors and goods and services as well as the harmonization of macroeconomic policies and the elimination of all tariff barriers. In addition to being a trading bloc, Mercosur also played an important political role in the region when its member countries acted in unison to oppose military coups in Paraguay and Ecuador.

Furthermore, Uruguay and Paraguay periodically voice objections to Argentina and Brazil's dominance of Mercosur and their tendency to reach bilateral policy agreements without consulting the two smaller countries. Uruguay produces only about 2 percent of Mercosur's GDP while Paraguay produces about 1 percent (see Chart 1). The most recent example of this problem came when Brazil and Argentina were negotiating over the automotive sector. Uruguay objected to being excluded from the process, and both Uruguay and associate member Chile claimed that the final agreement did not serve their national interests. The fact that there is such a significant disparity between the sizes of the Mercosur economies means that Argentina and Brazil will continue to dominate Mercosur's policy agenda, and such dominance will likely lead to periodic disagreements with the smaller countries.

The most serious policy obstacle to the process of integration within Mercosur has been the general failure to coordinate macroeconomic policies. As discussed earlier, Argentina's and Brazil's disparate exchange rate policies took their toll on trade relations within Mercosur in 1999. The Mercosur member nations have discussed coordinating common deficit, debt and inflation targets, much like the European Union did in the Maastricht Treaty. Such an arrangement could eventually pave the way for a single Mercosur currency. But reaching such policy goals does not appear likely anytime soon given disagreement over exchange rate policy and the lack of progress in fiscal harmonization. For example, Argentina is not considering departing from its fixed exchange rate policy, which has been in place since 1991, and Brazil has no plans to alter its flexible exchange rate. Consequently, any move to a single currency appears to be a long way off. Meanwhile, there is concern in Argentina over the potential fallout from further devaluation of Brazil's currency.

Reconciliation
Despite the recent tensions within Mercosur, there are signs that the crisis has eased. The recent elections of President Fernando De la Rua in Argentina and Jorge Batlle in Uruguay have brought a renewed impetus to “re-launch” Mercosur. In early 2000, Mercosur's leaders agreed to take steps toward creating a permanent tribunal for dispute settlement. They also declared that they would move toward greater macroeconomic coordination but, in the meantime, would not let the differences in Argentina's and Brazil's exchange rates serve as an obstacle. The Mercosur governments have plans to share and standardize macroeconomic data and set common inflation and fiscal goals in order to help avoid shocks like Brazil's 1999 devaluation. Furthermore, Brazil's President Cardoso has issued a call for more cross-investment and joint marketing of Mercosur-produced goods.

Mercosur's re-launching was further boosted by the announcement in late March that, after several years of negotiation and conflict, Argentina and Brazil agreed to establish a common automotive trade policy. The new rules will gradually reduce restrictions on trade in cars and trucks before eliminating restrictions entirely in 2006. Under the agreement, cars imported from outside Mercosur will face a 35 percent tariff, and for cars to be considered manufactured in Mercosur, they must have 60 percent Mercosur content.

Economic recovery
Recent economic indicators suggest that the region's economies are recovering, and improved economic performance will certainly contribute to relieving some of the trade disputes within Mercosur. Argentina's economy is expected to grow 3.4 percent in 2000 compared to 3.1 percent in 1999 while Brazil's economy is projected to grow 4 percent compared to just 0.5 percent in 1999. In March 2000, Argentine exports to Brazil were up 26.4 percent compared to March 1999 while automobile production was up 70 percent. Furthermore, with the automotive agreement settled and a renewed commitment from the Mercosur governments to coordinate macroeconomic policies and strengthen Mercosur's institutional framework, it appears that relations within Mercosur have improved.

Looking ahead, Mercosur could expand if Chile or Bolivia seeks full membership. Chile has expressed serious interest in becoming a full member of Mercosur, but its membership is unlikely to come about under the current tariff structure. Chile is engaged in a multiyear process of lowering its external tariffs, which were cut from 15 to 11 percent in 1991 and are currently scheduled to drop to 6 percent in 2003. Mercosur's average common external tariff remains significantly higher, at 14 percent. Bolivia has expressed interest in full membership but only as a long-term goal. Bolivia is already a member of the Andean Community, which is itself negotiating an agreement with Mercosur.

The negotiations with the Andean Community are an example of how Mercosur has sought to expand through negotiating trade agreements with other regional trading blocs. Participating in a hemispherewide Free Trade Area of the Americas (FTAA) agreement is a goal for Mercosur. But while FTAA negotiations appear stalled, Mercosur is actively pursuing trade agreements with the Andean Community, the European Union (EU) and South Africa.

THE RANGE OF EXPORTS TO THE MERCOSUR COUNTRIES FROM THE SOUTHEAST INCLUDES BOTH MANUFACTURED GOODS AND PRIMARY PRODUCTS. EXPORTS OF CHEMICAL PRODUCTS, PRIMARY METALS AND TOBACCO PRODUCTS TO MERCOSUR EXPANDED RAPIDLY IN THE 1990S.

Negotiations with the EU aim to liberalize trade in goods and services by 2005. Mercosur imports from the EU quadrupled from U.S.$6.1 billion to $26.6 billion between 1990 and 1998 while exports grew more slowly, from $14.4 billion to $20 billion (dollar amounts are not inflation-adjusted). The Mercosur countries want greater access to the EU market for their agricultural products, and Mercosur's demand that the EU lower agricultural subsidies will no doubt be a politically sensitive bargaining point as negotiations move forward.

The United States and Mercosur
The renewed spirit of cooperation within Mercosur is a positive development for the United States. In recent years U.S. foreign direct investment in the Mercosur countries and exports to the region have grown significantly. Foreign direct investment in Argentina, Brazil and Chile reached $46 billion in 1998, while U.S. exports to the Mercosur countries have grown almost 250 percent since 1991. South America is one of the few areas where the United States has run a trade surplus in recent years.

The Southeast is no exception to the trend. Exports to Argentina, Brazil and Chile from the Sixth Federal Reserve District states (Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee) have grown considerably since 1992 (see Chart 2). Exports to Brazil more than tripled from 1992 through 1998 while exports to Argentina grew nearly 80 percent during the same period.

The range of exports to the Mercosur countries from the Southeast includes both manufactured goods and primary products. Exports of chemical products, primary metals and tobacco products to Mercosur expanded rapidly in the 1990s. Tennessee saw tremendous growth in exports of paper and rubber and plastic products to Argentina; in Mississippi, exports of transportation equipment to Brazil surged. As in the rest of the country, overall levels of exports from the Southeast to the Mercosur countries declined in 1999. But current indicators suggest that exports to the region will recover in 2000.

A promising future
The year 1999 was by no means easy for Mercosur, but it is important to place it in perspective. If one considers that only 10 years ago Mercosur did not exist and the region was emerging from the "lost decade" of the 1980s (characterized by slow growth and the debt crisis), remarkable progress has been made. Governments in Latin America have now ended decades of closed, protectionist, state-led development and embraced freer trade and open markets. Inefficient state-owned enterprises are being privatized, and the region has reopened itself to foreign investment. Inflation has been lowered dramatically, and trade has expanded rapidly. From this perspective, recent trade disputes within Mercosur seem like a minor bump in the road, and there is every reason to believe that economic integration within Mercosur will deepen.

This article was written by Stephen Kay, a senior economic analyst in the Atlanta Fed's Latin America Research Group.

Regional Versus Multilateral TradeWhich Is Better?

egional trading arrangements (RTAs) like Mercosur and NAFTA have sprung up all over the globe in recent years: 46 were created between 1986 and 1994. But do RTAs contribute to or detract from global free trade? There is an ongoing debate over this issue. A fundamental principle of free trade is that countries cannot discriminate against foreign producers. But while RTAs liberalize trade within the bloc, by definition they discriminate against countries outside the trading area. The World Trade Organization recognizes that world trade can be enhanced through RTAs but states that the purpose of such agreements should be to facilitate trade within the bloc and not to raise barriers to trade with countries outside the bloc.

Furthermore, trading blocs simultaneously create trade, which is considered welfare-enhancing, and divert trade, which has a welfare cost. Trade creation takes place when lower-cost producers within the bloc replace a higher-cost domestic producer while trade diversion takes place when a lower-cost nonmember country is replaced by an otherwise higher-cost domestic producer protected by the trading bloc's barriers. If the amount of trade creation exceeds the amount of trade diversion, the members of the trading bloc are considered better off. If not, the members are worse off.

Economists are currently engaged in a debate over the merits of RTAs. Some argue that RTAs are biased toward trade diversion and that the current trend toward regionalism is creating obstacles to deepening global free trade. Others see RTAs much more positively, arguing that they are part of a deeper process of structural economic reform and a means through which countries undergoing economic liberalization can enter into the global trading system.

As these debates rage on, RTAs continue to thrive. For example, trade within Mercosur expanded by over 300 percent from 1990 through 1998, and Mercosur is currently negotiating a trade agreement with the European Union.